[Federal Register: June 22, 2000 (Volume 65, Number 121)]
[Proposed Rules]
[Page 39033-39039]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr22jn00-34]
-----------------------------------------------------------------------
COMMODITY FUTURES TRADING COMMISSION
17 CFR Part 35
RIN 3038-AB58
Exemption for Bilateral Transactions
AGENCY: Commodity Futures Trading Commission.
ACTION: Proposed Rulemaking.
-----------------------------------------------------------------------
SUMMARY: The Commodity Futures Trading Commission (Commission or CFTC)
is proposing to clarify the operation of the current swaps exemption,
17 CFR Part 35. In addition, in a companion notice of proposed
rulemaking on clearing, the Commission is proposing rules clarifying
that transactions under its Part 35 swaps exemption can be cleared. The
Commission, in companion releases published in this edition of the
Federal Register, also is proposing a new regulatory framework to apply
to multilateral transaction execution facilities, to market
intermediaries and to clearing organizations. This new framework
establishes a number of new market categories, including a category of
exempt multilateral transaction execution facility. Nothing in these
releases, however, would affect the continued vitality of the
Commission's exemption for swaps transactions under Part 35 of its
rules, or any of its other existing exemptions, policy statements or
interpretations.
DATES: Comments must be received by August 7, 2000.
ADDRESSES: Comments should be sent to the Commodity Futures Trading
Commission, Three Lafayette Centre, 1125 21st Street, NW., Washington,
DC 20581, attention: Office of the Secretariat. Comments may be sent by
facsimile transmission to (202) 418-5521 or, by e-mail to
secretary@cftc.gov. Reference should be made to ``Exemption for
Bilateral Transactions.''
FOR FURTHER INFORMATION CONTACT: Paul M. Architzel, Chief Counsel,
Division of Economic Analysis, Commodity Futures Trading Commission,
Three Lafayette Centre, 1125 21st Street, NW, Washington, DC 20581.
Telephone: (202) 418-5260. E-mail: [PArchitzel@cftc.gov].
SUPPLEMENTARY INFORMATION:
[[Page 39034]]
I. Background
The Commission is proposing to amend its Part 35 exemption to
expand and to clarify its operation, including the availability of
clearing for these transactions. These proposed amendments would
provide greater legal certainty to the OTC markets and reduce systemic
risk. The Commission was encouraged in this undertaking by the other
Federal financial regulators that comprise the President's Working
Group on Financial Markets \1\ and by the chairmen of the Commission's
Congressional oversight committees.
---------------------------------------------------------------------------
\1\ Recognizing the importance of the OTC derivatives markets,
the Chairmen of the Senate and House Agriculture Committees
requested that the President's Working Group on Financial Markets
(PWG) conduct a study of OTC derivatives markets. After studying the
existing regulatory framework for OTC derivatives, recent
innovations, and the potential for future developments, the PWG on
November 9, 1999, reported to Congress its recommendations. See
Over-the-Counter Derivative Markets and the Commodity exchange Act,
Report of the President's Working Group. The PWG report focused on
promoting innovation, competition, efficiency, and transparency in
OTC derivatives markets and in reducing systemic risk.
Although specific recommendations about the regulatory structure
applicable to exchange-traded futures were beyond the scope of its
report, the PWG suggested that the Commission review existing
regulatory structures (particularly those applicable to markets for
financial futures) to determine whether they were appropriately
tailored to serve valid regulatory goals.
---------------------------------------------------------------------------
The proposed amendments to part 35 respond to changes that have
occurred in the over-the-counter (OTC) markets since the Commission
adopted its Swaps Policy Statement in 1989, and its subsequent part 35
swaps exemption in 1993. In the intervening years, the OTC derivatives
markets have experienced dramatic and sustained growth. During this
period, OTC financial derivatives have developed into global markets
having outstanding contracts with a total notional value of over $80
trillion. OTC derivatives have transformed finance, increasing the
range of financial products available for managing risk.
II. Legal Certainty for Bilateral OTC Transactions
The Commission is proposing to amend its part 35 swaps exemption in
a number of ways. First, it is proposing to delete specific reference
to ``swaps'' within the exemption itself. Instead, the rule would refer
to a ``contract, agreement or transaction'' that meets the requisite
exemptive conditions. This is being proposed to clarify that an
instrument's denomination as a ``swap'' was not, and is not, an
independent condition of the exemption. Moreover, as suggested by the
PWG Report, the Commission has also proposed to delete the requirement
that exempt transactions not be fungible or standardized and has made
clear that insofar that such exempt transactions may be cleared,
creditworthiness of the counterparty is not a condition of the
exemption. PWG Report at 17-18. In addition, the Commission is
proposing, through an exemption from the private right of action
provision of section 22 of the Act, that transactions entered into in
reliance on the part 35 swaps exemption would not be subject to a claim
for rescission solely due to a violation of the exemption's
requirements. See Id. at 18.
The Commission has proposed these changes to its part 35 swaps
exemption in order to enhance the legal certainty for such instruments.
These changes would in no way call into question any transaction
undertaken under the part 35 rules as currently drafted. Moreover, in
recognition of its continuing vitality and to assist the public in
locating it, the Commission is proposing to incorporate by reference
its 1989 Swaps Policy Statement as Appendix A to part 35.\2\ Moreover,
the Commission is not proposing any changes to its energy
interpretation (55 FR 39188) and energy exemption (58 FR 21286) and
affirms their continued applicability.
---------------------------------------------------------------------------
\2\ The Swaps Policy Statement is found at 54 FR 30694 (July 21,
1989).
---------------------------------------------------------------------------
A condition of the part 35 exemption is that such transactions not
be entered into and traded on or through a ``multilateral transaction
execution facility'' (MTEF). The Commission is proposing to define MTEF
in amendments to part 36 of its rules included in a companion release
published in this edition of the Federal Register. The Commission is
proposing to define MTEF as ``an electronic or non-electronic market or
similar facility through which persons, for their own accounts or for
the accounts of others, enter into, agree to enter into or execute
binding transactions by accepting bids or offers made by one person
that are open to multiple persons conducting business through such
market or similar facility.'' This definition highlights the essential
nature of an MTEF as a place or facility through, or on, which traders
have the ability to execute agreements or contracts. It does not,
however, require that every trader have access to every transaction
offered through the facility. The definition as proposed does not, and
is not intended to, ``preclude participants from engaging in privately
negotiated bilateral transactions, even where these participants use
computer or other electronic facilities, such as `broker screens,' to
communicate simultaneously with other participants so long as they do
not use such systems to enter orders to execute transactions.'' See, 58
FR 5587, 5591 (Jan. 22, 1993). Accordingly, the proposed definition
makes clear that it does not include facilities merely used as a means
of communicating bids or offers nor does it include markets in which a
single party offers to enter into bilateral transactions with multiple
counterparties who may not transact with each other.
As proposed, the Commission would not make any determination that
the exempted transactions are or are not subject to its jurisdiction.
When it adopted Section 4(c) in 1992, the Conferees of the Congress
stated:
The Conferees do not intend that the exercise of exemptive
authority by the Commission (under section 4(c)) would require any
determination beforehand that the agreement, instrument, or
transaction for which an exemption is sought is subject to the Act.
Rather, this provision provides flexibility for the Commission to
provide legal certainty to novel instruments where the determination
as to jurisdiction is not straightforward.\3\
---------------------------------------------------------------------------
\3\ H.R. Rep. No. 978, 102d Cong., 2d Sess. 82-83 (1992).
---------------------------------------------------------------------------
III. Section 4(c) Findings
These proposed rule amendments are being proposed under section
4(c) of the Act, which grants the Commission broad exemptive authority.
Section 4(c) of the Act provides that, in order to promote responsible
economic or financial innovation and fair competition, the Commission
may by rule, regulation or order exempt any class of agreements,
contracts or transactions, either unconditionally or on stated terms or
conditions. To grant such an exemption, the Commission must find that
the exemption would be consistent with the public interest, that the
agreement, contract, or transaction to be exempted would be entered
into solely between appropriate persons and that the exemption would
not have a material adverse effect on the ability of the Commission or
any contract market to discharge its regulatory or self-regulatory
duties under the Act.\4\
---------------------------------------------------------------------------
\4\ See 7 U.S.C. 6(c).
---------------------------------------------------------------------------
As explained above, the proposed exemption for bilateral
transactions is available only to appropriate persons. Moreover, these
amendments to part 35 will promote financial innovation and reduce
systemic risk. The Commission further finds that these proposed
amendments would have no adverse effect on any of the regulatory or
self-regulatory responsibilities imposed by the Act. The Commission
specifically
[[Page 39035]]
requests the public to comment on these findings.
IV. Related Matters
A. Regulatory Flexibility Act
The Regulatory Flexibility Act (RFA), 5 U.S.C. 601 et seq.,
requires that agencies, in promulgating rules, consider the impact of
these rules on small entities. Information of the type that would be
required under the proposed rule does not involve any small
organizations.
B. Paperwork Reduction Act
The Paperwork Reduction Act (PRA) of 1995 (44 U.S.C. 3507(d)),
which imposes certain requirements on federal agencies (including the
Commission) in connection with their conducting or sponsoring any
collection of information as defined by the PRA does not apply to this
rule. The Commission believes the proposed amendments to this rule do
not contain information collection requirements which require the
approval of the Office of Management and Budget. The purpose of these
proposed rule amendments is to provide greater legal certainty for the
specified OTC transactions.
List of Subjects in 17 CFR Part 35
Commodity futures, Commodity Futures Trading Commission.
In consideration of the foregoing, and pursuant to the authority
contained in the Commodity Exchange Act and, in particular, sections 2,
4, 4(c), and 8a thereof, 7 U.S.C. 2, 6, 6c, and 12a, the Commission
hereby proposes to amend Chapter I, Part 35 of Title 17 of the Code of
Federal Regulations as follows:
PART 35--EXEMPTION OF BILATERAL AGREEMENTS
1. The authority citation for Part 35 continues to read as follows:
Authority: 7 U.S.C. Secs. 2, 6, 6c, and 12a.
2. The heading of part 35 is proposed to be revised as set forth
above.
3. Section 35.1 is proposed to be amended by revising paragraph (b)
to read as follows:
Sec. 35.1 Scope and definitions.
* * * * *
(b) Definition. As used in this part, ``eligible participant''
means, and shall be limited to, the following persons or classes of
persons:
(1) A bank or trust company (acting on its own behalf or on behalf
of another eligible participant);
(2) A savings association or credit union;
(3) An insurance company;
(4) An investment company subject to regulation under the
Investment Company Act of 1940 (15 U.S.C. 80a-1 et seq.) or a foreign
person performing a similar role or function subject as such to foreign
regulation, provided that such investment company or foreign person is
not formed solely for the specific purpose of constituting an eligible
participant;
(5) A commodity pool formed and operated by a person subject to
regulation under the Act or a foreign person performing a similar role
or function subject as such to foreign regulation, provided that such
commodity pool or foreign person is not formed solely for the specific
purpose of constituting an eligible participant and has total assets
exceeding $5,000,000;
(6) A corporation, partnership, proprietorship, organization,
trust, or other entity not formed solely for the specific purpose of
constituting an eligible participant:
(i) Which has total assets exceeding $10,000,000, or
(ii) The obligations of which under the agreement are guaranteed or
otherwise supported by a letter of credit or keepwell, support, or
other agreement by any such entity referenced in this paragraph
(b)(6)(i) of this section or by an entity referred to in paragraph
(b)(1), (2), (3), (4), (5), (6) or (8) of this section; or
(iii) Which has a net worth of $1,000,000 and enters into the
agreement in connection with the conduct of its business; or which has
a net worth of $1,000,000 and enters into the agreement to manage the
risk of an asset or liability owned or incurred in the conduct of its
business or reasonably likely to be owned or incurred in the conduct of
its business;
(7) An employee benefit plan subject to the Employee Retirement
Income Security Act of 1974 or a foreign person performing a similar
role or function subject as such to foreign regulation with total
assets exceeding $5,000,000, or whose investment decisions are made by
a bank, trust company, insurance company, investment adviser subject to
regulation under the Investment Advisers Act of 1940 (15 U.S.C. 80a-1
et seq.), or a commodity trading advisor subject to regulation under
the Act;
(8) Any governmental entity (including the United States, any
state, or any foreign government) or political subdivision thereof, or
any multinational or supranational entity or any instrumentality,
agency, or department of any of the foregoing;
(9) A broker-dealer subject to regulation under the Securities
Exchange Act of 1934 (15 U.S.C. 78a et seq.) or a foreign person
performing a similar role or function subject as such to foreign
regulation, acting on its own behalf or on behalf of another eligible
participant: Provided, however, that if such broker-dealer is a natural
person or proprietorship, the broker-dealer must also meet the
requirements of either paragraph (b)(6) or (11) of this section;
(10) A futures commission merchant, floor broker, or floor trader
subject to regulation under the Act or a foreign person performing a
similar role or function subject as such to foreign regulation, acting
on its own behalf or on behalf of another eligible participant:
Provided, however, that if such futures commission merchant, floor
broker, or floor trader is a natural person or proprietorship, the
futures commission merchant, floor broker, or floor trader must also
meet the requirements of paragraph (b)(6) or (b)(11) of this section;
or
(11) Any natural person with total assets exceeding at least
$10,000,000.
4. Section 35.2 is proposed to be revised to read as follows:
Sec. 35.2 Exemption.
A contract, agreement or transaction is exempt from all provisions
of the Act and any person or class of persons offering, entering into,
rendering advice, or rendering other services with respect to such
agreement, is exempt for such activity from all provisions of the Act
(except in each case the provisions enumerated in Sec. 35.3(a))
provided the following terms and conditions are met:
(a) The contract, agreement or transaction is entered into solely
between eligible participants;
(b) The contract, agreement or transaction is not entered into and
traded on or through a multilateral transaction execution facility as
defined in Sec. 36.1 of this chapter; and
(c) Except for those contracts, agreements or transactions
submitted for clearance or settlement to a clearinghouse as provided
under paragraph (d)(3) of this section, the creditworthiness of any
party having an actual or potential obligation under the contract,
agreement or transaction would be a material consideration in entering
into or determining the terms of the contract, agreement or
transaction, including pricing, cost, or credit enhancement terms.
(d) The provisions of paragraphs (b) and (c) of this section shall
not be deemed to preclude:
(1) Arrangements or facilities between parties to such contracts,
agreements or transactions that provide for netting of payment
obligations resulting from such contracts, agreements or transactions;
[[Page 39036]]
(2) Arrangements or facilities among parties to such contracts,
agreements or transactions, that provide for netting of payments
resulting from such contracts, agreements or transactions;
(3) The submission of such contracts, agreements or transactions
for clearance and/or settlement to a clearing organization which is
authorized under Sec. 39.2 of this chapter; or
(4) The use of an electronic or non-electronic market or similar
facility used solely as a means of communicating bids or offers by
market participants or the use of such a market or facility by a single
counterparty to offer to enter into or to enter into bilateral
transactions with multiple counterparties.
(e) Any person may apply to the Commission for exemption from any
of the provisions of the Act (except section 2(a)(1)(B)) for other
arrangements or facilities, on such terms and conditions as the
Commission deems appropriate, including but not limited thereto, the
applicability of other regulatory regimes.
5. Section 35.3 is proposed to be added to read as follows:
Sec. 35.3 Enforceability.
(a) Notwithstanding the exemption in Sec. 35.2, sections
2(a)(1)(B), 4b, and 4o of the Act, Sec. 32.9 of this chapter as adopted
under section 4c(b) of the Act, Sec. 32.13 of this chapter, and
sections 6(c) and 9(a)(2) of the Act to the extent that they prohibit
manipulation of the market price of any commodity in interstate
commerce or for future delivery on or subject to the rules of any
contract market, continue to apply to transactions and persons
otherwise subject to those provisions.
(b) A party to a contract, agreement, or transaction that is with
an eligible participant (or counterparty reasonably believed by such
party to be an eligible counterparty) shall be exempt from any claim,
counterclaim or affirmative defense by such counterparty under section
22(a)(1) of the Act or any other provision of the Act:
(1) That such contract, agreement, or transaction is void, voidable
or unenforceable; or
(2) to rescind or recover any payment made in respect of such
contract, agreement, or transaction, based solely on the failure of
such party or such contract, agreement, or transaction to comply with
the terms or conditions of the exemption under this part or from the
terms or conditions of the Statement of Policy Concerning Swap
Transactions in appendix A to this part 35.
(c) A party to a contract, agreement or transaction that qualifies
under the Statement of Policy Concerning Swap Transactions in appendix
A to this part 35 or the Statutory Interpretation Concerning Hybrid
Instruments, as the same may be revised by the Commission from time to
time, shall be exempt from any claim under Section 22(a)(1) of the Act
or any other provision of the Act:
(1) That such contract, agreement or transaction is void, voidable,
or unenforceable; or
(2) to rescind or recover any payment made in respect of such
contract, agreement or transaction, based solely on the failure of such
party, or such contract, agreement or transaction, to comply with any
provision of the Act or Commission rules, excluding, in the case of
this paragraph, any claim for manipulation or fraud arising under a
provision of the Act or Commission rules applicable by its terms to a
contract, agreement or transaction that is not otherwise subject to
regulation under the Act.
6. Part 35 is proposed to be amended by adding new Appendix A to
read as follows:
Appendix A to Part 35--Policy Statement Concerning Swap Transactions
(a) Background
(1) Section 2(a)(1)(A) of the Commodity Exchange Act (CEA or
Act) grants the Commission exclusive jurisdiction over ``accounts,
agreements (including any transaction which is of the character of *
* * an `option' * * *), and transactions involving contracts of sale
of a commodity for future delivery traded or executed on a contract
market * * * or any other board of trade, exchange, or market. * *
*'' 7 U.S.C. 2. The CEA and Commission regulations require that
transactions in commodity futures contracts and commodity option
contracts, with narrowly defined exceptions, occur on or subject to
the rules of contract markets designated by the CFTC.\1\ In several
recent releases \2\ and in response to requests for case-by-case
review of various proposed offerings,\3\ the Commission has
addressed the applicability of the Act and Commission regulations to
various forms of commodity-related instruments offered and sold
other than on designated contract markets. An overview of off-
exchange transactions and issues was commenced by issuance in
December 1987 of an Advance Notice of Proposed Rulemaking (Advance
Notice). The Advance Notice requested comment concerning, among
other things, a proposed no-action position concerning certain
commercial transactions, which, as described, would have extended to
certain categories of swap transactions.
---------------------------------------------------------------------------
\1\ 7 U.S.C. 6(a), 6c(b), 6c(c). Section 4(a) of the CEA
provides, inter alia, that it is unlawful to enter into a commodity
futures contract that is not made ``on or subject to the rules of a
board of trade which has been designated by the Commission as a
`contract market' for such commodity.'' 7 U.S.C. 6(a). This
prohibition does not apply to futures contracts made on or subject
to the rules of a foreign board of trade, exchange or market. 7
U.S.C. 6(a). The exchange trading requirement reflects Congress's
view that such an environment would control speculation and promote
hedging. H.R. Rep. No. 44, 67th Cong., 1st Sess. 2 (1921). See also
7 U.S.C. 5 (Congressional findings concerning necessity for
regulation of futures and commodity option transactions). Pursuant
to Sections 4c(b) and 4c(d), 7 U.S.C. 6c(b) and 6c(d), of the CEA,
the Commission has authority to permit transactions in commodity
options which do not take place on contract markets. Currently, only
two narrow categories of such option transactions exist: trade
options (in which the offeree is a ``commercial user'' of the
underlying commodity) and dealer options (in which the grantor
fulfills the criteria of Section 4c(d)(1) of the CEA). See also 54
FR 1128 (January 11, 1989) (Proposed Rules Concerning Regulation of
Hybrid Instruments); Final Rules Concerning Regulation of Hybrid
Instruments, published elsewhere in this issue.
\2\ 52 FR 47022 (December 11, 1987) (Advance Notice of Proposed
Rulemaking); 54 FR 1139 (January 11, 1989) (Statutory Interpretation
Concerning Certain Hybrid Instruments); 54 FR 1128 (January 11,
1989) (Proposed Rules Concerning Regulation of Hybrid Instruments).
See also 50 FR 42963 (October 23, 1985) (Statutory Interpretation
and Request for Comments Concerning Trading in Foreign Currencies
for Future Delivery).
\3\ The Commission staff's Task Force on Off-Exchange
Instruments has addressed a number of proposed offerings of hybrid
instruments in a series of published ``no-action'' letters. See,
e.g., CFTC Advisory No. 39-88, June 23, 1988 [Interpretative Letter
No. 88-10, June 20, 1988, 2 Comm. Fut. L. Rep. (CCH) para. 24,262]
(notes indexed to dollar/Yen exchange rate); CFTC Advisory No. 45-
88, July 19, 1988 [Interpretative Letter No. 88-11, July 13, 1988, 2
Comm. Fut. L. Rep. (CCH) para. 24,284] (notes indexed to dollar/Yen
exchange rate); CFTC Advisory No. 48-88, July 26, 1988
[Interpretative Letter No. 88-12, July 22, 1988, 2 Comm. Fut. L.
Rep. (CCH) para. 24,285] (notes indexed to dollar/foreign currency
exchange rate); CFTC Advisory No. 58-88, August 30, 1988
[Interpretative Letter No. 88-16, August 26, 1988, 2 Com. Fut. L.
Rep. (CCH) para. 24,312] (federally-chartered corporation issuing
notes indexed to nationally disseminated measure of inflation
published by a U.S. government agency); CFTC Advisory No. 63-88,
September 21, 1988 [Interpretative Letter No. 88-17, September 6,
1988, 2 Comm. Fut. L. Rep. (CCH) para. 24,320] (fixed-rate
debentures with additional payments indexed to the price of natural
gas over an established base price); CFTC Advisory No. 66-88,
September 23, 1988, 2 Comm. Fut. L. Rep. (CCH) para. 24,321
(certificates of deposit with interest payable at maturity indexed
in part to the spot price of gold). See also CFTC Advisory No. 18-
19, March 17, 1989 (letter dated November 23, 1988, concerning
proposed sale of hay for delayed delivery).
---------------------------------------------------------------------------
(2) Based upon careful review of the comments received in
response to the Advance Notice, indicating generally a need for
greater clarity in this area, representations from market users, and
consultations with other federal regulators concerning the issues
raised by swap transactions, the Commission is issuing this policy
statement to clarify its view of the regulatory status of certain
swap transactions. This statement reflects the Commission's view
that at this time most swap transactions, although possessing
elements of futures or options contracts, are not appropriately
regulated as such under the Act and regulations. This policy
statement is intended to recognize a non-exclusive safe harbor for
transactions satisfying the requirements set forth herein.
[[Page 39037]]
(b) Safe Harbor Standards
(1) In determining whether a transaction constitutes a futures
contract, the Commission and the courts have assessed the
transaction ``as a whole with a critical eye toward its underlying
purpose.'' \4\ Such an assessment entails a review of the ``overall
effect'' of the transaction as well as a determination as to ``what
the parties intended.'' \5\ Although there is no definitive list of
the elements of futures contracts, the CFTC and the courts recognize
certain elements as common to such contracts.\6\ Futures contracts
are contracts for the purchase or sale of a commodity for delivery
in the future at a price that is established when the contract is
initiated, with both parties to the transaction obligated to fulfill
the contract at the specified price. In addition, futures contracts
are undertaken principally to assume or shift price risk without
transferring the underlying commodity. As a result, futures
contracts providing for delivery may be satisfied either by delivery
or offset.
---------------------------------------------------------------------------
\4\ CFTC v. Co. Petro Marketing Group, Inc., 680 F.2d 573, 581
(9th Cir. 1982).
\5\ CFTC v. Trinity Metals Exchange, No. 85-1482-CV-W-3 (W.D.
Mo. January 21, 1986] [citing CFTC v. National Coal Exchange, Inc.
[1980-1982 Transfer Binder] Comm. Fut. L. Rep. (CCH) para. 21,424 at
26,046 (W.D. Tenn. 1982)].
\6\ See generally, 52 FR 47022, 47023 (December 11, 1987)
(citing In the Matter of First National Monetary Corp., [1984-1986
Transfer Binder] Comm. Fut. L. Rep. (CCH) para. 22,698 (CFTC 1985));
Letter to the Honorable Patrick Leahy and the Honorable Richard
Lugar, Committee on Agriculture, Nutrition and Forestry, United
States Senate, from Wendy L. Gramm, Chairman, Commodity Futures
Trading Commission, dated May 16, 1989 (Attachment at 7-8). The
Commission has explained that this does not mean that ``all
commodity futures contracts must have all of these elements * * *''
In re Stovall, [1977-1980 Transfer Binder] Comm. Fut. L. Rep. (CCH)
para. 20,941 (CFTC 1979). To hold otherwise would permit ready
evasion of the CEA.
---------------------------------------------------------------------------
(2) In addition to these necessary elements, the CFTC and the
courts also recognize certain additional elements common to
exchange-traded futures contracts, including standardized commodity
units, margin requirements related to price movements, clearing
organizations which guarantee counterparty performance, open and
competitive trading in centralized markets, and public price
dissemination.\7\ These additional elements facilitate the trading
of futures contracts on exchanges and historically have developed in
conjunction with the growth of organized contract markets. The
presence or absence of these additional elements, however, is not
dispositive of whether a transaction is a futures contract.\8\
---------------------------------------------------------------------------
\7\ E.g., Advance Notice, 52 FR at 47023; Letter to the
Honorable Patrick Leahy and the Honorable Richard Lugar, Committee
on Agriculture, Nutrition and Forestry, United States Senate, from
Wendy L. Gramm, Chairman, Commodity Futures Trading Commission,
dated May 16, 1989 (Attachment at 8); OGC Statutory and Regulatory
Interpretation (Regulation of Leverage Transactions and Other Off-
Exchange Future Delivery-Type Instruments), 50 FR 11656, 11657, n.2
(March 25, 1985); CFTC v. Co Petro Marketing Group, Inc., 680 F.2d
573 (9th Cir. 1982).
\8\ In addition, the Commission and the courts have consistently
recognized that ``the requirement that a futures contract be
executed on a designated contract market is what makes the contract
legal, not what makes it a futures contract.'' In the Matter of
First National Monetary Corp., [1984-1986 Transfer Binder] Comm.
Fut. L. Rep. (CCH) para. 22,698 at 30,975 (CFTC 1985); In re
Stovall, [1977-1980 Transfer Binder] Comm. Fut. L. Rep. (CCH) para.
20,941 at 23,776 (CFTC 1979). See, also, Interpretative Statement,
``The Regulation of Leverage Transactions and Other Off-Exchange
Future Delivery Type Investments-Statutory Interpretation,'' 50 FR
11656 (March 25, 1985).
---------------------------------------------------------------------------
(3) In general, a swap may be characterized as an agreement
between two parties to exchange a series of cash flows measured by
different interest rates, exchange rates, or prices with payments
calculated by reference to a principal base (notional amount).\9\
Commenters have described the swap market as one in which the
customary large transaction size effectively limits the market to
institutional participants rather than the retail public.\10\ Market
participants also have noted that swaps typically involve long-term
contracts, with maturities ranging up to twelve years.\11\ In
addition to these characteristics, many comparisons between swaps
and futures contracts have stressed the tailored, non-standardized
nature of swap terms; the necessity for particularized credit
determinations in connection with each swap transaction (or series
of transactions between the same counterparties); the lack of public
participation in the swap markets; and the predominantly
institutional and commercial nature of swap participants. Other
commenters have stressed that, despite these distinctions in the
manner of trading of swaps and exchange products, the economic
reality of swaps nevertheless resembles that of futures contracts.
---------------------------------------------------------------------------
\9\ See generally, Bank for International Settlements, Recent
Innovations in International Banking at 37-60 (April 1986); S. K.
Henderson, ``Swap Credit Risk: A Multi-Perspective Analysis,'' 44
Business Lawyer 365 (1989). Interest rate swaps have been described
as having three primary forms: coupon swaps (fixed rate to floating
rate swaps); basis swaps (swap of one floating rate for another
floating rate); and cross-currency interest rate swaps (swaps of
fixed rate payments in one currency to floating rate payments in
another currency). Currency swap transactions involve agreements
between two parties providing for exchanges of amounts in different
currencies which are calculated on the basis of a pre-established
interest rate, a specified exchange rate, and a specified notional
amount. Commodity swaps generally include swap transactions similar
in structure to interest rate swaps, except that payments are
calculated by reference to the price of a specified commodity, such
as oil.
\10\ The average notional amount for swaps has been estimated at
$24 million. Letter from the New York Clearing House to CFTC, dated
April 6, 1989, commenting on Proposed Rule and Statutory
Interpretation Concerning Certain Hybrid and Related Instruments.
\11\ E.g., Letter to CFTC from the International Swap Dealers
Association, Inc., dated April 8, 1988, concerning Advance Notice;
letter to CFTC from Morgan Guaranty Trust Company of New York, dated
April 11, 1988, concerning Advance Notice.
---------------------------------------------------------------------------
(4) The Commission recognizes that swaps generally have
characteristics, such as individually-tailored terms, predominantly
commercial and institutional participants, and expectation of being
held to maturity, rather than offset during the term of the
agreement, that may warrant distinguishing them from futures
contracts. The criteria set forth below identify certain swaps for
which regulation under the CEA and Commission regulations is
unnecessary. These safe harbor standards are consistent with
policies reflected in the CEA's jurisdictional exclusion for forward
contracts,\12\ the Treasury Amendment,\13\ and the trade option
exemption,\14\ and are otherwise consistent with Section 2(a)(1)(A)
of the CEA. Although these jurisdictional and exemptive or
exclusionary provisions are not sufficiently broad to provide clear
exemptive boundaries for many swaps, they reflect policies relevant
to the safe harbor policy set forth herein and may encompass certain
swap transactions.\15\
---------------------------------------------------------------------------
\12\ Section 2(a)(1)(A) of the CEA provides that the term
``future delivery'' does not include sales of any cash commodity for
deferred shipment or delivery. 7 U.S.C. 2. Sales of cash commodities
for deferred delivery, or forward contracts, generally have been
recognized to be commercial, merchandising transactions in physical
commodities entered into by commercial counterparties who have the
capacity to make or take delivery of the underlying commodity but in
which delivery ``may be deferred for purposes of convenience or
necessity.'' 52 FR 47027; In re Stovall, [1977-1980 Transfer Binder]
Comm. Fut. L. Rep. (CCH) para. 20,941 at 23,777-78 (CFTC 1979). The
forward contract exclusion may apply to certain types of swap
transactions.
\13\ The Treasury Amendment provides that ``[n]othing in this
Act shall be deemed to govern or in any way be applicable to
transactions in foreign currency, security warrants, security
rights, resales of installment loan contracts, repurchase options,
government securities, or mortgages and mortgage purchase
commitments, unless such transactions involve the sale thereof for
future delivery conducted on a board of trade.'' 7 U.S.C. 2. See
generally, 50 FR 42963 (October 23, 1985) (CFTC Statutory
Interpretation). See also, Commodity Futures Trading Commission v.
American Board of Trade, 473 F. Supp. 117 (S.D.N.Y. 1979), aff'd,
803 F.2d 1242 (2d Cir. 1986). The Treasury Amendment may apply to
some types of transactions also characterized as swaps.
\14\ The trade option exemption, which is set forth in Rule
32.4(a), 17 CFR 32.4(a) (1988), authorizes commodity option
transactions, other than those on commodities specified in rule
32.2(a), that are not executed on a designated contract market and
that are:
Offered by a person which has a reasonable basis to believe that
the option is offered to a producer, processor, or commercial user
of, or a merchant handling the commodity which is the subject of the
commodity option transaction, or the products or byproducts thereof,
and that such producer, processor, commercial user or merchant is
offered or enters into the commodity option transaction solely for
purposes related to its business as such.
It should be noted that under Rule 32.4(a), only the offeree of
the trade option need qualify as a ``commercial user'' or
``merchant.'' Rule 32.4(a) is silent concerning which party to a
trade option may be the option buyer of a put or call or ``long,''
and which party may be the option seller of a put or call or
``short.'' As a result, provided that the qualifying commercial
offeree is entering the trade option transaction solely for non-
speculative purposes demonstrably related to its commercial business
in the commodity which is the subject of the option transaction, the
requirements of Rule 32.4(a) are met.
\15\ The forward contract inclusion facilitates commodity
transactions within the commercial merchandising chain. The trade
option exemption similarly may be viewed as facilitating principal-
to-principal transactions in which the offeree is a commercial party
with respect to the underlying commodity. The Treasury Amendment
reflects Congressional intent to avoid duplicative regulation of
foreign currency transactions and other transactions in the
interbank market supervised by bank regulatory agencies.
---------------------------------------------------------------------------
[[Page 39038]]
(5) Consequently, the Commission has determined that a greater
degree of clarity may be achieved through safe harbor guidelines
establishing specific criteria for swap transactions to which the
Commission's regulatory framework will not be applied. Swaps
satisfying the requirements set forth below will not be subject to
regulation as futures or commodity option transactions under the Act
and regulations. This policy statement addresses only swaps settled
in cash, with foreign currencies considered to be cash.\16\
---------------------------------------------------------------------------
\16\ As noted previously, certain categories of swap
transactions may be subject to the forward contract exclusion, the
Treasury Amendment and the trade option exemption. The safe harbor
criteria set forth herein apply equally to options on swaps.
---------------------------------------------------------------------------
(i) Individually-Tailored Terms
(A) Individual tailoring of the terms of swap agreements is
frequently cited as indispensable to the operation of the swap
market. Commenters have indicated that swap agreements are based
upon individualized credit determinations and are tailored to
reflect the particular business objectives of the counterparties.
Tailoring occurs through private negotiations between the parties
and may involve not only financial terms but issues such as
representations, covenants, events of default, term to maturity, and
any requirement for the posting of collateral or other credit
enhancement. Such tailoring and counterparty credit assessment
distinguish swap transactions from exchange transactions, where the
contract terms are standardized and the counterparty is unknown. In
addition, the tailoring of swap terms means that, unlike exchange
contracts, which are fungible, swap agreements are not fully
standardized.
(B) To qualify for safe harbor treatment, swaps must be
negotiated by the parties as to their material terms, based upon
individualized credit determinations, and documented by the parties
in an agreement or series of agreements that is not fully
standardized.\17\ This requirement is intended to exclude from safe
harbor treatment instruments which are fungible and therefore may be
readily transferred and traded.
---------------------------------------------------------------------------
\17\ Formation of swaps pursuant to a master agreement between
two counterparties that establishes some or all contract terms for
one or more individual swap transactions between those
counterparties is not precluded by this requirement, provided that
material terms of the master agreement and transaction
specifications are individually tailored by the parties.
---------------------------------------------------------------------------
(ii) Absence of Exchange-Style Offset
(A) Exchange-traded futures contracts generally may be
terminated by offset,\18\ that is, liquidated through establishment
of an equal and opposite position. For exchange-traded futures
contracts, the universal counterparty to each cleared position is
the clearing organization. Prior consent of the clearing
organization, as counterparty, is unnecessary to offset.\19\
---------------------------------------------------------------------------
\18\ In the context of exchange-traded futures, offset refers to
the liquidation of a futures position through the acquisition of an
opposite position. Availability of such offset, resulting in the
liquidation of the position, typically is established by exchange
rules governing exchange members' relationships with the clearing
house. See, e.g., Chicago Mercantile Exchange Rule 808 (``a clearing
member long or short any commodity to the Clearing House as a result
of substitution may liquidate the position by acquiring an opposite
position for its principal''); Board of Trade Clearing Corporation
Regulation 705.00 (``Where a member buys and sells the same
commodity for the same delivery, and such contracts are cleared
through the Clearing House, the purchases and sales shall be offset
to the extent of their equality, and the member shall be deemed a
buyer from the Clearing House to the extent that his purchases
exceed his sales, or a seller to the Clearing House to the extent
that his sales exceed his purchases''); New York Futures Exchange
Rule 3-4 (``As between the Clearing Corporation and the original
parties to futures contracts and option contracts, such contracts
shall be binding upon the original parties until liquidated by
offset, delivery, exercise or expiration, as the case may be''). Of
course, the ability to offset in any given case depends upon the
availability of a counterparty to enter into an offsetting
transaction at an acceptable price.
\19\ However, the ability to liquidate contractual positions
through offset is established by clearing organization rules to
which all clearing members consent.
---------------------------------------------------------------------------
(B) In contrast, swap transactions have been described as
transactions which create performance obligations terminable only
with counterparty consent and which generally are expected to be
maintained to maturity. A swap counterparty who seeks to eliminate
the economic effect of a swap agreement may enter into a reverse
swap agreement, that is, a second swap with the same maturity and
payment requirements, with the same or a new counterparty, but in
which the party seeking to eliminate its economic exposure assumes
the reverse position (in this case the obligations of each party to
both transactions continue to maturity). A swap counterparty who
seeks to terminate, absent default, its obligations under a swap
agreement may: (1) Undertake a swap sale in which, based upon
consent of the counterparty, it assigns its rights and obligations
under the swap to a third party; or (2) negotiate an early
termination of the transaction, or swap ``closeout,'' in which it
negotiates a lump-sum payment with its counterparty to terminate the
swap.\20\ In the latter two cases, termination of the obligations
created by a swap is dependent upon consent of the counterparty.
---------------------------------------------------------------------------
\20\ Swap parties may agree in advance upon a termination
formula or price for the swap.
---------------------------------------------------------------------------
(C) To qualify for safe harbor treatment, the swap must create
obligations that are terminable, absent default, only with the
consent of the counterparty. If consent to termination is given at
the outset of the agreement and a termination formula or price
fixed, the consent provision must be privately negotiated. This
requirement is intended to confine safe harbor treatment to
instruments that are not readily used as trading vehicles, that are
entered into with the expectation of performance, and that are
terminated as well as entered into based upon private negotiation.
(iii) Absence of Clearing Organization or Margin System
(A) As noted above, the necessity for individualized credit
determinations has been described as a hallmark of swap
transactions. A number of commenters have stressed both the
dependence of the current swap market on such determinations and the
absence of a multilateral ``credit support'' mechanism, such as a
clearing organization, for swaps. In accordance with the concept of
swaps as dependent upon private negotiation and individualized
credit determinations as to the capacity of certain parties to
perform, this safe harbor is applicable only to swap transactions
that are not supported by the credit of a clearing organization and
that are not primarily or routinely supported by a market-to-market
margin and variation settlement system designed to eliminate
individualized credit risk.\21\ The ability to impose individualized
credit enhancement requirements to secure either changes in the
credit risk of a counterparty or increases in the credit exposure
between two counterparties consistent with the above criteria would
not be affected.
---------------------------------------------------------------------------
\21\ Several commenters urged the Commission to adopt a safe
harbor for swaps that would be conditioned upon, among other things,
the absence of a credit support mechanism. See Letter to CFTC from
Sullivan & Cromwell, dated April 8, 1988, concerning Advance Notice,
at 41-42; Letter to CFTC from Manufacturers Hanover, dated April 11,
1988, concerning Advance Notice, at 4. The safe harbor standard is
based upon individualized credit determinations at the outset and
during the pendency of the contract.
---------------------------------------------------------------------------
(iv) The Transaction is Undertaken in Conjunction With a Line of
Business
(A) The absence of public participation in the swaps market has
frequently been cited as a factor supporting different regulatory
treatment of swaps and futures contracts. Swap market participants
are predominantly institutional and commercial entities such as
corporations, commercial and investment banks, thrift institutions,
insurance companies, governments, and government-sponsored or
chartered entities.\22\
---------------------------------------------------------------------------
\22\ Letter dated April 8, 1988, to CFTC from International Swap
Dealers Association, Inc. Concerning Advance Notice.
---------------------------------------------------------------------------
(B) The safe harbor set forth herein is limited to swap
transactions undertaken in conjunction with the parties' line of
business.\23\ This restriction is intended to preclude public
participation in qualifying swap transactions and to limit
qualifying transactions to those based upon individualized credit
determinations. This restriction does not preclude dealer
transactions in swaps undertaken in conjunction with a line of
business, including financial intermediation services.
---------------------------------------------------------------------------
\23\ Swap transactions entered into with respect to exchange
rate, interest rate, or other price exposure arising from a
participant's line of business or the financing of its business
would be consistent with this standard.
---------------------------------------------------------------------------
(v) Prohibition Against Marketing to the Public
Swap transactions eligible for safe harbor treatment may not be
marketed to the public. This restriction reflects the institutional
and commercial nature of the existing swap market and the
Commission's intention to
[[Page 39039]]
restrict qualifying swap transactions to those undertaken as an
adjunct of the participant's line of business.
(c) Conclusion. This policy statement is intended to clarify the
regulatory treatment of certain transactions in order to facilitate
legitimate market transactions in a field distinguished by
innovation and rapid growth. Consequently, the Commission proposes
to continue to review on a case-by-case basis transactions that do
not meet the above criteria and that are not otherwise excluded from
Commission regulation.
Issued in Washington, D.C., this 8th day of June, 2000, by the
Commission.
Jean A. Webb,
Secretary of the Commission.
[FR Doc. 00-14917 Filed 6-21-00; 8:45 am]
BILLING CODE 6351-01-U